Document Sample
					Introduction to Financial
Statement Analysis

Fundamental Concepts and
 Introduction to Financial
Introduction to Financial Statement
• Analysis of financial statement is the systematic
  numerical calculations of the relationship between
  one fact with the other to measure the
  profitability, operational, efficiency, solvency and
  the growth potential of Business.
• A major source of information regarding a firm’s
  operating performance and its resources is the
  firm’s financial statement package.
• Analyzing a set of financial statements involves
  using ratios of key financial statement items and
  other tools to gain insight into the profitability and
  risk of a firm.
• Financial statement analysis can help us to better
  understand the business risk and the financial risk
  of a firm.
  Tom Rourke
  Purpose of Financial Statements
• Financial    statements      are    a    structured
  representation of the financial position (Balance
  Sheet) and financial performance (Income
  Statement) of an entity.
• The objective of financial statements is to provide
  information about the financial position, financial
  performance and cash flows of an entity that is
  useful to a wide range of users in making
  economic decisions.
• Financial statements also show the results of
  management’s       stewardship     (Planning     &
  Management) of the resources entrusted to it. To
  meet this objective, financial statements provide
  information about an entity’s:

Purpose of Financial Statements (Cont.)

  (a) assets
  (b) liabilities
  (c) equity
  (d) income and expenses, including gains and losses
  (e) other changes in equity; and
  (f) cash flows

  • This information, along with other information in the
    notes, assists users of financial statements in predicting
    the entity’s future cash flows and, in particular, their
    timing and certainty.
Component of Financial Statements

A complete set of financial statements comprises:
• a balance sheet;
• an income statement;
• a statement of changes in equity showing
   – all changes in equity, or
   – changes in equity other than those arising
       from transactions with equity holders
       acting in their capacity as equity holders;
• a cash flow statement; and
• notes, comprising a summary of significant
    accounting policies and other explanatory
Principal Financial Statements

• Financial statements are intended to
  provide information on the operating
  performance and financial health of a
  business during a specified period of time.
• In the US, financial statements are required
  to stick to GAAP (although GAAP does
  allow some flexibility).
  – One goal is to make the financial statements of
    one firm comparable across time and to the
    financial statements of other firms.
 Tom Rourke
Principal Financial Statements,
• GAAP requires firms to present balance
  sheets for the two most recent years and
  income statements and statements of cash flows
  for the three most recent years in a set of
  financial statements.
• In addition, firms are required to present
  notes to the financial statements that provide
  information on the accounting methods
  used by the firm to construct the financial

  Tom Rourke
Users of Financial Statements
Users    of       the       financial Interest of the user
Equity investors        (existing   and They are interested whether buy, hold or sell the
potential)                              shares in hand and also enable them in payment of
Loan creditors ie, existing and The amount will be paid when due and for
potential holders of debentures and continuation of the business.
loan stock, and providers of short-
term loans
Employees (existing, potential and Interested in stability and profitability for
past)                              employment opportunities, remuneration and
                                   retirement benefits.
Business     contacts     including Whether the payment of loan will be made in due
customers,     trade      creditors, dates and enable sustainability of business for future
competitors and potential take-over business with the enterprise.
Government,         including   tax Interested in allocation of resources and also to
authorities, government departments regulate the activities of an enterprise and
and local authorities               determining tax policies and as a basis for national
Public, including tax payers, Trends and recent development in the prosperity of
ratepayers and environmental groups the entity and range of it’s activities.
Financial Statement
Analysis Framework
• The financial statement analysis
  framework includes the following
  – Identify the purpose and objectives of the
  – Review the financial statements, notes
    and audit opinion.
  – Determine whether restatements are
    necessary to enhance the comparability of
    the statements.
Financial Statement Analysis
Framework (Cont. 1)
 – Determine whether the firm's size, capital
   structure, and product mix are
   appropriate to proceed with the ratio
 – Conduct horizontal and vertical analyses
   of each financial statement, with special
   emphasis on the income statement.
 – Calculate the basic liquidity ratios.
 – Calculate profitability ratios based on net
   income and on cash flow from operating
   activities. Evaluate trends.
Financial Statement Analysis
Framework (Cont. 2)
  – Evaluate the firm's capital structure with
    special emphasis on trends in the
    percentage composition ratios.
  – Examine the firm's market performance
    using the investor ratios.
  – Examine any inconsistencies in the ratio
    results, review notes, and recalculate the
Financial statement analysis:
Tools and approaches

Tools:                     Approaches used with each tool:

                           1. Time-series analysis: the same firm
  Common size statements      over time (e.g., Wal-Mart in 2008 and

                           2. Cross-sectional analysis: different
  Trend statements            firms at a single point in time (e.g.,
                              Wal-Mart and Target in 2008).

                           3. Benchmark comparison: using
  Financial ratios
                              industry norms or predetermined
  (e.g., ROA and ROCE)        standards.
Limitations of Financial
Statement Analysis
• Financial statement analysis is limited
  due to several items.
  – GAAP presents some limits.
  – Managers often have the ability to select
    favorable accounting methods.
  – Many major factors affecting profitability
    and survival of the firm are not included
    in the financial statements.
     • A perfect example is human resources.
Limitations of Financial
Statement Analysis (Cont.)
      • While employees are often a firm's most
        important asset, a value for employees does
        not appear on the balance sheet.
• Financial statement analysis relies on past
  numbers, and the past may not be a reliable
  indication of the future.
Basic Assumptions for Preparation of
    Financial Statements
 Over all considerations of preparing and presenting financial
  – Business Entity
  – Fair Presentation and Compliance with IFRS
  – Going Concern or Continuity
  – Time Period
  – Monetary Unit
  – Historical Cost
  – Realization
  – Matching
  – Consistency
  – Full Disclosure
  – Materiality and Aggregation
  – Off setting
  – Comparative Information
Basic Assumptions
  Business Entity
• The concept of Business Entity means that business or
  entity is a separate and distinct from the owners of the
  entity for which financial statements are prepared

   Fair Presentation and Compliance with
• Financial statements shall present fairly the financial
  position, financial performance and cash flows of an
  entity. Fair presentation requires the faithful
  representation of the effects of transactions, other events
  and conditions in accordance with the definitions and
  recognition criteria for assets, liabilities, income and
  expenses set out in the Framework.
Basic Assumptions
 Going Concern
• The going-concern assumption is that the entity will
  remain in the business for an indefinite period of time,
  provides viewpoint on the future of the entity. This
  assumption deliberately disregards the possibility that the
  entity will go bankrupt or liquidated. If a particular entity
  is in fact threatened with bankruptcy or liquidation then
  going concern assumption should be dropped.
  Time Period
• The only accurate way to account for the success or failure
  of an entity is to accumulate all transactions from the
  opening of the business until the business eventually
  Monetary Unit
• Accountants needs some standard of measure to bring
  financial transactions together in a meaningful way.
  Accountant should specify the unit of measure i.e $ or
  PKR according to the country in which statements is
Basic Assumptions
 Historical Cost
• Historical cost is used in practice because it is objective
  and determinable. The Assets are recorded in financial
  statements on historical cost.
 Consistency of Presentation
• The presentation and classification of items in the
  financial statements shall be retained from one period to
  the next unless:
   • it is apparent, following a significant change in the
      nature of the entity’s operations or a review of its
      financial statements, that another presentation or
      classification would be more appropriate having
      regard to the criteria for the selection and application
      of accounting policies.
Basic Assumptions
• Accountants need to recognize the costs associated with
  the recognized revenue. The basic intent is to determine
  the revenue first and then match the appropriate costs
  against this revenue.
• Cost of inventory can be easily matched with revenue.

• While preparing FS, Accountants need to determine that
  when it is practical to recognize revenue.
  Full Disclosure
• The accounting report must disclose all facts that may
  influence the judgment of an informed reader. Several
  method of disclosure exit such as footnotes and cross
Basic Assumptions
Materiality and Aggregation
Each material class of similar items shall be presented
separately in the financial statements. Items of a dissimilar
nature or function shall be presented separately unless they
are immaterial.

Off setting
Assets and liabilities, and income and expenses, shall not
be offset unless required or permitted by a Standard or an

Comparative Information
Except when a Standard or an Interpretation permits or
requires otherwise, comparative information shall be
disclosed in respect of the previous period for all amounts
reported in the financial statements. Comparative
information shall be included for narrative and descriptive
information when it is relevant to an understanding of the
current period’s financial statements.
 Basic Assumptions
 Transaction Approach
        A transaction is any event that affects the
           financial position of an organization
                 and requires recording.

There are two approaches of transaction recording:
  Accrual Basis of Accounting
  An entity shall prepare its financial statements, except for
  cash flow information, using the accrual basis of
      – The accrual basis of accounting recognizes revenues and
         expenses when they occur regardless of when cash is
                          received or disbursed.
  Cash Basis of Accounting
  The cash basis of accounting recognizes revenue and
  expense when cash is received and disbursed.
Financial Statements – Reporting
The reporting frame work that is applicable in Pakistan while preparing
and presenting of financial statements is as follows:
                     Applicable Laws and Regulations                          Regulating
Listed Companies     •Companies Ordinance 1984.                               Securities and
other than,          •International Financial Reporting Framework (IFRS)      Exchange
Insurance, NBFCs’,   as applicable in Pakistan                                Commission of
Modaraba and Bank    •Stock Exchange Listing Regulations                      Pakistan (SECP)

Banking Companies    •International Financial Reporting Framework (IFRS)      Securities and
                     as applicable in Pakistan                                Exchange
                     •Companies Ordinance 1984.                               Commission of
                     •Stock Exchange Listing Regulations (Particularly Code   Pakistan and State
                     of Corporate Governance)                                 Bank of Pakistan.
                     •Banking Ordinance 1962
                     •Prudential Regulations (Corporate, SMEs’ and

Insurance            •International Financial Reporting Framework (IFRS)      Securities and
Companies            as applicable in Pakistan                                Exchange
                     •Companies Ordinance 1984                                Commission of
                     •Stock Exchange Listing Regulations                      Pakistan.
                     •Insurance Ordinance and Rules
Financial Statements – Reporting
Framework (Cont.)

                    Applicable Laws and Regulations                Regulating
Non Banking         •International Financial Reporting Framework   Securities and
Finance Companies   (IFRS).                                        Exchange
(Leasing            •Companies Ordinance 1984.                     Commission of
Companies,          •Stock Exchange Listing Regulations            Pakistan.
Investment          (Particularly Code of Corporate Governance)
                    •NBFC Rules.
                    •Prudential Regulations for NBFCs’
                    •Prudential Regulations for Leasing Company

Modarba             •International Financial Reporting Framework   Securities and
                    (IFRS).                                        Exchange
                    •Companies Ordinance 1984.                     Commission of
                    •Stock Exchange Listing Regulations            Pakistan and
                    (Particularly Code of Corporate Governance)    Registrar of
                    •Modarba Act and Rules
   Tom Rourke
Why     Do     We Audit            Financial
 In this section we look at the following:

 • Need for audit
 • Objective of the audit
Need for Audit
                          Principle provides capital
                             and hires manager
                                 to manage it.

                          Information asymmetry
  Principle                                                    Directors
(Shareholders)          and conflict of interest lead
                    to information risk for the principle
            Director is accountable to Principle;
                 provides financial reports.

                                                       Directors hires
Auditor gathers                                        auditors to report
evidence to evaluate                                   on the fairness of
fairness of manager                Auditor
                                                       manager financial
financial statements.                                  statements. Risk
                                                       asymmetry of
                                                       principle reduce.
Objective of Audit

   The objective of the audit is to express an
   opinion on the financial statements whether or
   not the financial statements present fairly.

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